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Bond Prices Explained

Bond Prices ExplainedHow is a Bond Valued?

Bond prices are determined through a stringent valuation process to calculate the “fair price” of a bond. As is common with any capital investment or security, the value in theory of a bond is the present value of the stream of cash flows that are expected to generate upon maturity. As a result the prices of the bond are obtained by discounting the bond’s expected return (or cash flow) to the present by using the appropriate discount rate. The discount rate, in practice, is typically determined by referencing the underlying bond to other similar instruments, provided that the instrument still exists and maintains a uniform formatting.

Bond prices also fluctuate based on the presence of embedded options within the bond. The valuation process in this formatting is more difficult and will combine option pricing with pure discounting. Depending on the type of option within the bond, the option price is either added to or subtracted from the price of the straight portion of the underling bond. Subsequently, this total is then the true value of the bond and the various yields of the bond can thus be calculated for the total bond price.
The fair bond price of a straight bond (bonds with no embedded option) is typically determined by discounting the expected cash flows at the coordinating discount rate. This present value relationship reflects the bond price in theory and the theoretical approach used to determine the bond prices. In practice bond prices are usually determined with reference to other, more liquid financial instruments. There are two predominant ways in which a bond can be evaluated and subsequently priced:

Relative Bond Price Approach:

Using this approach, a bond will be priced relative to a benchmark asset, typically a government security. Using this approach, the yield to maturity attached to the bond is determined based on the bond’s Credit rating (the likelihood that the bond will be paid back) compared to a government security with a similar maturity schedule. The higher the quality of the bond, the smaller the spread between its expected return and the yield to maturity benchmark. The expected return is subsequently used to discount the bond’s return to obtain bond prices.
Arbitrage-Free Pricing Model:
Using this approach, bond prices reflect the arbitrage-free price of the bond market. The cash flow (the face or coupon value) is separately discounted at the same rate as a zero-coupon bond with an equivalent credit score. In general, bond prices are evaluated under this method by applying rational pricing logic relating to assets with identical cash flows.
More specifically, the bond’s coupon dates and the amounts of the couple are known with certainty; therefore some fraction of a cero-coupon bond and each corresponding coupon date can be specified as to produce identical cash flows to the bond. As a result, the bond price presently must be equal to the sum of each of the cash flows, which are discounted at the rate implied by the value of corresponding zero coupon bond.

Coupons: What you must know

Coupons: What you must know

What are Coupons in regards to Finance?

• In finance, a coupon refers to the rate of payment offered by a bond; it is the interest paid per year expressed as a percentage of the face value of the fixed-income security. More simply put, the coupon is the interest rate that a bond issuer pays to a bond holder.
• Originally known as a “bearer bond”, the coupon signifies the issuer’s debt obligation; the coupon is offered as a semi-annual interest payment to the bond’s holder. The yield of the coupon is simply the coupon payment as a percentage of the face value; coupon yield=C/F.
Example of a Bond Coupon:
• If you hold a $20,000 bond described as a 5% loan stock, you will receive $1,000 in interest each year—typically these payments will be delivered in two installments or as a semi-annual payment. The coupon, therefore for this example, is expressed as 5% or $1,000 in total. 
• Not all bonds or fixed-income investments are attached with coupon payments; zero-coupon bonds, for example, are those that do not pay interest to the holder–Investment in such bonds are secured because the fixed-income instrument is sold at a discount or at a price less than the bond’s par value. When held to maturity, these bonds are redeemed for par value. 
• The origin of the coupon payment stems from the fact that bonds were originally issued as bearer certificates, so that obtainment of a certificate was conclusive proof of ownership. Several coupons, one for each scheduled interest payment covering a number of years, where printed on each certificate. At the due date (when the bond matures and the holder is paid back his or her principal) the holder would physically detach the coupon and present it for payment of the interest shown. 
How are Bonds priced?
• Because the coupon is the interest paid over the course of a bond’s life to the holder, a bond is priced in direct proportion to the coupon rate, the maturity date and its rating. Furthermore, the amounts and dates of the coupons will determine the bond price; obviously, the higher the coupon payments the riskier or more expensive the bond will be. In most cases, those issuers who have lower bond ratings will attempt to encourage investment by offering a higher coupon rate or a discounted price. 

Fixed Income: A Brief Guide

Fixed Income: A Brief Guide

What does Fixed Income mean?
• Fixed income refers to any type of investment security which is not equity and that obligates the issuer to make periodic or fixed payments to the purchaser/holder. If you lend money to a borrower and the borrower is required to pay interest once a quarter, you have entered into a fixed-income agreement. 
• Common fixed income instruments include the majority of investments who offer the holder a fixed rate of return that is either guaranteed or considered less risky than owning stocks or derivatives. Common examples of fixed income instruments include: bonds (both corporate and government issued), treasury bills, CDs, commercial paper etc. 
• A government body will issue bonds or fixed income instruments as a means to increase financing in the short term; the money obtained from investors or citizens purchasing the bonds is used to pay-off debts or fund public supplies. In turn, the holder of the bond enjoys fixed interest payments attached to a guarantee that their principal will be paid in full when the bond matures. 
• Companies can also issue fixed-income instruments, such as corporate loans or corporate bonds for the same purpose. These bonds, similar to government bonds may also be traded between investors on an open exchange format. 
How does a Fixed Income Security contrast with an Equity?
• A fixed income security contrasts with equity securities—assuming the equity does not pay a dividend—because the rate of return is unexpected with a stock. As a result, the term “fixed” income refers only to the schedule of obligatory payments, delivered by the issuer to the bond or debt holder. A fixed income security may dependent on a variable interest rate, therefore necessitating a difference in the rate of pay, but still maintaining the schedule of payments. 
• If an issuer of a fixed-income security goes in default or misses a payment, the bond’s holder can force the underlying company or government agency into bankruptcy. In contrast, for a stock, if a company misses a quarterly dividend payment, there is no violation of the payment covenant and no presence of a default. 
Terms Associated with Fixed-Income Instruments:
• The following terms are commonly associated with bonds or other fixed-income securities:
o The Issuer: Refers to the entity, such as a company or government agency, who borrows any amount of money (the forma l issuance of the fixed-income security) and promises to pay interest. 
o The Principal: Also referred to as the maturity value, par value or face value, the principal amount is the amount of money the issuer borrows from the lender; the principal must be repaid to the lender when the bond matures
o The Coupon: Refers to the interest rate attached to the bond. 
o The indenture: Refers to the contract attached to the fixed income agreement; the indenture will state all the terms of the bond.
o The maturity: Refers to the date at which the bond is redeemed; on this date the issuer is required to return the principal to the holder.